It Costs Money to Sell a Lot of Bonds

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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One basic fact about markets is that, if there are 1,000 widgets in the world, and the "fair" price of a widget is $100, and you need to sell 200 widgets in an afternoon, you will probably get less than $100 per widget for them. If you need to buy 200 widgets in an afternoon, you'll probably pay more than $100 per widget. If you need to do anything, you'll pay. Financial markets are good at identifying need and extracting value from it.

You can give various names to this phenomenon, but one sometimes useful way to think about it is as "bid-ask spread." The fair price for a widget is $100. If you need to sell a widget right now, some intermediary will let you sell immediately, but will charge you a bit for that service. Say you'll get $99.90 for your widget. If you need to buy a widget right now, you will also be charged for immediacy, and pay maybe $100.10. Sometimes you'll want to buy and I'll want to sell at exactly the same time, and we'll trade with each other at exactly $100, but, especially in a market where widgets don't trade all that often, that coincidence will be rare. Mostly we will both pay for immediacy.

If you need to sell 200 widgets all at once, the odds that I will also need to buy 200 widgets at exactly the same time are low. In fact the odds are low that anyone will need to buy that many widgets in, like, a week. So you'll pay even more, as a percentage of "fair value," for immediacy. Perhaps you'll sell your widgets for $98 each, instead of $100. That $2 per widget surcharge is the price you pay for getting a whole lot of immediacy.

The bond market is a bit like the widget market, in that most individual bonds don't trade all that often. (You may have heard that people are worried about bond market liquidity.) But it is also a pretty well-studied market, and we can replace those illustrative fake widget numbers with real, or semi-real, bond numbers. So here is a February blog post from the Federal Reserve Bank of New York on liquidity in the U.S. corporate bond market. Some relevant schematic facts:

An average U.S. corporate bond with $1 billion outstanding trades a bit more than $2 million of bonds a day, and a bit less than $800,000 at a time. That is, in an average day, there are about three trades in that bond, each of about $800,000.

The average bid-ask spread for a bond like that is a bit more than a half-percentage point of par, call it 0.6 percent. That is, if you want to buy a bond with a fair value of $100, you'll probably pay about $100.30 (an extra 0.3 percent, or half the bid-ask spread); if you want to sell that bond, you'll probably get about $99.70.

These are very rough averages that I have obtained by eyeballing lines on charts, so I insist that you don't take them too seriously, but they are perhaps in the vague neighborhood of right. You can slice the data more finely: The New York Fed shows volume and bid-ask spreads for different issue sizes, and as you'd expect, bigger issues have more trading and lower bid-ask spreads. It also breaks down bid-ask spreads by credit rating: AAA-rated bonds have an average bid-ask spread of less than 0.7 percent, while B-rated bonds are above 1 percent.

Now, what happens if you want to sell a whole lot of bonds all at once? Instead the typical trade of selling, say, $1 million of a bond with $1 billion outstanding, and paying around 0.3 percent ($3,000) for liquidity, you want to sell, say, $1 billion worth of a bond with zero bonds outstanding. That is: You want to issue a brand-new bond, and sell all of it in one day. What sort of bid-ask spread should you pay? First principles would tell you that if selling a few bonds from a large bond issue costs 0.3 percent, then selling 100 or 1,000 times as many bonds -- especially brand-new bonds -- should cost ... I mean, not 100 or maybe even 10 times as much, but more, anyway. No?

Well, now we have an answer, sort of. Here is Bloomberg's Tracy Alloway on a study done by Fideres Partners LLP on the pricing of new-issue U.S. corporate debt, which came to the following conclusion:

Fideres found that the price of corporate bonds typically increases by 0.50 percent between the day the price of the new debt is announced and the day it’s issued, compared to a 0.15 percent rally in newly-issued U.S. government bonds in the same time frame. Bonds sold by junk-rated companies with more fragile balance sheets tend to increase by 1.5 percent, while top-tier investment-grade corporate debt enjoys just a 0.40 percent rally.

Simplistically -- and of course I am oversimplifying all over the place here -- you can think of that 0.5 percent as being the price that the companies pay for immediacy. The "fair value" of a bond is, say, $100, the company sells it for $99.50, and it quickly increases by $0.50 to its $100 fair value.

That 0.5 percent discount, to sell the entire issue of a brand-new bond, is a little less than twice the 0.3 percent discount that you'd pay to sell $1 million of an already-existing $1 billion bond. That's ... not so bad, right? You are getting a lot more immediacy for your money, but you're not paying that much more for it. There is a catch, though: The way to sell tons of bonds at such a tiny discount to fair value is by marketing those bonds, using an investment bank to try to persuade investors to buy them and build a book of demand to take down all the new supply. And you have to pay the bank too. The average bank fee for investment-grade U.S. corporate bond deals so far this year is about 0.43 percent; the average fee for high-yield U.S. deals is about 1.08 percent.

So your all-in cost of immediacy, for selling the entire amount outstanding of a brand-new bond, is about 0.83 percent for an investment grade bond, and about 2.58 percent for a high-yield bond.Those numbers are something like three to five times the cost of selling a small percentage of the bonds outstanding in a large already-existing issue.

That strikes me as about right, but what do I know, and you may disagree.

You know who disagrees? Fideres Partners, who did the study. This shouldn't be too much of a surprise. Fideres is a business, and it is in the business of helping investors sue banks for conspiracies, so it has an interest in finding bank conspiracies that investors can sue for. And it thinks that the cost of immediacy in corporate bond issuance may be a conspiracy:

“Corporate bonds’ price in the days after their issuance may hint to a systemic underpricing by major dealers,” Fideres, which has previously researched the rigging of the Libor benchmark interest rate, wrote in new research published this week. The firm estimates that the underpricing of new debt may have cost U.S. companies as much as $18 billion in extra interest in bonds issued between 2010 and 2015 by ratcheting up their borrowing costs at a time when benchmark interest rates were at ultra-low levels.

Now: It may be a conspiracy! John Lefevre, the former Citigroup Asia bond syndicate manager and current Twitter elevator, who can't seem to stop himself from confessing to fraud in public, tweets of his time in bond syndicate: "we’d show fake order books (limit orders) to misprice deals, and repay favors via allocation." As Alloway has written, this new-issue pop has been one of the best ways for investors to make money in the bond markets in the last few years. Investors like it when banks sell them new-issue bonds that quickly go up in price, and reward those banks with more trading business. The banks, in turn, like to sell cheap new-issue bonds to their best clients. It looks a bit like a symbiotic relationship between banks and investors at the expense of the issuers.

But remember that the issuers want the investors to like new-issue bonds. The issuers are the ones selling the bonds! If they never went up in value -- if they were sold at exactly fair value -- what would be the incentive for investors to buy them? Remember, the average bond with $1 billion outstanding trades just $2 million a day. If you were trying to sell $1 billion of bonds at fair value, it would take you two years. The issuers need immediacy, and the investors are thrilled to give it to them -- for a price.

There are other ways to conceptualize this new-issue discount, by the way. The issuer faces asymmetric risks: Selling the bond a little too cheap is no big deal, but failing to get a deal done is an embarrassing disaster, so the issuer (and the bank) has incentives to underprice the bonds to make sure the deal gets done. Investors do take risk by buying a brand-new bond with no trading history, so they expect to be compensated for that risk in the form of a lower price. Also, the banks are selling their services as underwriters in part by being repeat players: Banks want to underprice bonds when things are good to create loyalty among their customers, so that when market conditions are tough they'll still be able to count on those customers to buy new bonds. This helps issuers in hard times, though it might cost some issuers some money now.

But let me make a more general point. Financial markets have frictions. More than that: Financial markets are frictions. Financial markets are about moving money from one place to another, and they take out a tiny bit of that money to pay the middleman for that service. (Wolfe is famously instructive.) It is the normal condition of financial markets that outsiders will tend to assume that those frictions are fraud, or theft, or rent-seeking or otherwise Bad. (Many of them are!) Why should investors get a free 0.5 percent return just for buying new bonds? Why should high-frequency traders make money every day? None of these people are growing crops, or building houses, or curing cancer or composing symphonies. They are just moving money around. What have they done to deserve to keep any of it?

That objection sometimes has a lot of force, and sometimes not so much. But the mere fact that a friction exists doesn't prove that it is a conspiracy. The middlemen are, after all,moving the money -- and someone wants them to do it. They are expending effort and skill and taking risk to do it, and you shouldn't be surprised if they're compensated for it. Not every friction in financial transactions is a conspiracy. Sometimes, it's a market.

You can think about it as "price impact," too, if you want. There is very little science in any of this; it is a sketch of how things work, not a blueprint.

Both those numbers are higher than my 0.6 percent estimate above, presumably because of different aggregation. That is, my 0.6 percent estimate was for $1 billion issue sizes, which is a biggish bond; the aggregation by rating presumably includes a lot of smaller bonds with wider bid-asks.

The issue sizes and date ranges and so forth in the Fideres study are not really comparable to the New York Fed post, etc.; none of this should be taken as at all scientific. But the margin for error here is pretty big, and I believe that most of my assumptions are chosen to be conservative, that is, to undermine my argument here.

Similarly, the 1.5 percent discount on a junk bond is about 3 times the 0.5 percent discount (half the 1 percent bid-ask spread) you'd pay to do a normal trade in a BB rated bond.

Treasury market bid-ask spreads, on the other hand, are very tight. The typical bid-ask on a 10-year Treasury is a bit over 1/64 of a point, round it up to 0.02 percent. So the "normal" price of immediacy for a trade, half the bid-ask spread, is just 0.01 percent. But a new-issue Treasury comes at a discount to "fair value" that is 15 times as big as the normal cost of immediacy. That looks pretty big, compared to the corporate market -- which is part of why people are suing banks for manipulating Treasury auctions.

Source: Bloomberg's LEAG function, for "US Investment Grade Corporate Bonds" and "US High Yield Corporate Bonds." Not all fees are publicly disclosed, so this might be skewed.

Alloway mentions one other piece of evidence for that, along with its refutation:

“As an aside, Fideres also performed some preliminary analysis that shows that dealers actually have a good track record of pricing their own bonds in a competitive manner so that they minimize the premium that they pay to the market,” the research firm wrote. The average price jump shortly after such bonds’ announcement date is about 0.30 percent, compared to the 0.50 percent seen by the wider corporate debt universe, the firm noted. Results, however, may be skewed as big banks tend to be large issuers of debt and so may enjoy a premium compared to some other types of companies.

That "however" matters. You pay more for immediacy in less liquid issues.

That's just, like, $1 billion divided by $2 million is 500, and there are about 260 trading days in a year. This is obviously fake math and the statement in the text is an exaggeration, but the numbers are the numbers.

Sometimes called a "new-issue premium," confusingly, because the issuers pay a premium (in spread) while the investors get a discount.

This morning I quoted Kevin Drum on the mysterious rise in the percentage of gross domestic product spent on finance:

I know I'm probably revealing more ignorance here than I should, but how did this happen? Finance isn't a monopoly. In fact, it's one of the most globalized, fluid, and competitive industries on the planet. Why haven't its profits long since been reduced to zero, or close to it? I can understand occasional blips as markets change—CDOs and SIVs get hot for a while, so experts in CDOs and SIVs make a killing—but the overall industry? How has it managed to hold onto such outlandish rents for such a sustained period?

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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